Current global events should motivate you to focus on certain pressing questions. Here is one of the most vital questions to consider:
Is my investment portfolio balanced and resilient enough to withstand market volatility or do I need to diversify more fully?
This article will:
Give an overview of the importance of diversification
Encourage you to consider adding real estate investment to your portfolio to add stability
Explain how you can diversify your investments even within the sphere of real estate
Investment Diversification – An Overview
Why is diversification of your investments so important?
Diversification is the very best way to minimize risk. Every investor has different investment goals and it is important to have a clear view of your own, whether it is saving for retirement or for more short-term goals, focusing on your ultimate aims will enable success.
Of course, differing investment goals also means different risk tolerance which will have an impact on your investment portfolio. Whether your investment goals allow you to tolerate slightly more risk or not, it is important to analyze risk reduction strategies. Diversification is an excellent way to add stability and reduce risk while not affecting a portfolio’s wealth building capacity.
How does diversification achieve this risk reduction?
This is mainly achieved by ensuring your portfolio is spread across different types of investment that will each react differently to the same event.
The key with diversification is to try to limit the correlation between your investments. Simply investing in more financial assets does not mean better diversification if those assets are strongly related. For example, buying stocks in multiple companies of the same type is risky because a single event may cause all of those stocks to devalue. Due to globalization, asset classes are also becoming more correlated than in the past.
In view of the fact, that unexpected events can impact investment, you should certainly consider adding real estate to diversify and stabilize your investment portfolio. This reduces exposure to unsystematic risk by diversifying your investments and ensuring that they are not closely correlated to one another.
Add Stability to Your Portfolio by Investing in Real Estate
Many investors shy away from diversifying their portfolio with a real estate investment because of their inability to liquidate that investment quickly. In actual fact, it is this illiquid quality of real estate investment that can anchor and stabilize your investment portfolio!
Real estate is a tangible asset and as such for many investors, feels more real. It is an asset that engenders confidence. A great appeal of this type of investment is its stability. For many millions of people, this kind of investment has generated consistent wealth and long-term appreciation.
Real estate investment provides passive investors a very consistent and stable rental income. Having a home is a vital necessity for all people, and as a result, rental investors are relatively protected even during economic downturns.
As we have seen, your portfolio’s long term resilience lies in diversification across different asset classes.
Due to the different buying and selling dynamics of the private market, private real estate investment benefits from low correlation to the performance of stocks and bonds unlike publicly traded real estate investment trusts aka (REITs). That is why they are great options for diversification against unsystematic risk and are thus considered crucial to a clear strategy for diversification.
Even within the percentage of your portfolio that includes real estate investment we encourage further diversification subsequently reducing risk even further.
Diversification in Your Real Estate Investments
How can you create a diversified real estate investment portfolio?
There are three main areas where we encourage diversification. These are:
Geography
Asset Class
Operator
Geography Diversification
Although the risk is relatively small, having all your real estate investments in one geographic location is like having all your eggs in one basket.
A real estate investment in a certain area affected by extreme weather for example, might typically perform well, but would it be wise to have all of your real estate investments in that one area?
Aside from weather issues, there are economic factors such as one area being heavily dependent on one particular employer or one particular type of employer.
Although it would likely be wise to invest in that area in certain circumstances, if there is some major issue that affects that one industry or employer then that area might become vulnerable.
For these reasons, it is wise to spread your investments in real estate over a wide and varied geographical area as your portfolio grows.
Asset Class Diversification
When it comes to investing in multifamily properties, certain asset classes perform better in a growing economy while others weather a downturn more effectively.
As your portfolio expands try to diversify as much as possible within the range of risk that you are comfortable with. (Some asset classes such as hotels may be too high risk for your liking.) The goal is for your cash flow/returns to remain consistent.
Operator Diversification
As a passive investor in a multifamily syndication, you are putting trust in the operator of the deal. Since the day to day running of the operation is taken care of by the operator this leaves you free to diversify and invest in multiple syndication deals. By doing so, you will not have 100% of your real estate investment capital with any one operator.
To summarize, advanced diversification affords investors the opportunity to increase return potential and reduce portfolio volatility. This is particularly true when diversifying into investing in real estate and when investing across various geographical locations as well as different asset classes and with more than one operator. While the details of the diversification are down to you, it is sure that the more advanced and carefully planned the diversification, the stronger and safer your investment will be!
Investing in real estate is an endeavor as rewarding as other investment vehicles such as stocks or bonds but can involve a lesser degree of management in monitoring your holdings (especially if you’re engaged in apartment syndications). So, what is the best way to generate income from real estate?
In this article, we will focus on rentals. Specifically, we’ll identify which type of real estate investment you might find better: Apartment Syndications or Single-Family Rentals.
First, let’s define these two. Apartment Syndications are, simply put, the pooling of money from numerous investors to buy an apartment complex which will then be fixed up, if needed, and rented out. This is a partnership where a manager handles the transactions of the rental property while you, along with other investors fund the endeavor.
Single-Family Rentals (SFRs) are self-explanatory—you buy single-family homes, fix them up for a cost if necessary and then rent them out.
Now, let’s differentiate between the two in terms of cost. Naturally, single-family homes are typically cheaper as a whole than multi-family apartments; although apartment complexes often come out cheaper on a per-unit or “door” basis. So, if you’re simply looking at a $100,000 single-family home compared to a $1,000,000 apartment complex, the difference in the cost would be staggering. However, we’re talking about apartment syndication here, which means that the cost to acquire an apartment complex is divided among the investors, so, you won’t have to worry about shelling out as big of an amount.
Apart from acquisition costs, you also have to deal with repair costs. When buying any property, repair costs are usually incurred. You want the place to be in pristine condition so that you can rent it out sooner and at a good price.
For both single-family rentals and apartment syndications, repair costs would naturally depend on the condition of the property when you bought it. The only difference between the two is how much of the cost you shoulder. With SFRs, you don’t have anyone to share the burden with, compared to joining apartment syndications, where the General Partner (GP) takes care of the arrangement, and you typically just pay a fraction of the cost.
Another thing you have to consider is maintenance expenses. In a typical lease agreement, renters do not shell out money for maintenance and upkeep, so these costs would all have to be shouldered by the lessor.
If you’re managing one or multiple single-family rentals by yourself, you have to pay for the costs out of pocket. Logistics would also have to be considered if you have to visit multiple properties all at the same time, just for maintenance. In apartment syndications, the partnership may bring in or hire a third-party property manager, who’ll take care of the maintenance, the cost of which will be spread among all investors.
Vacancies are where you have real leverage when it comes to apartment syndications. Suppose you only manage one single-family rental. What happens when that becomes vacant? Your cash flow will come to a halt until another tenant occupies it. In contrast, when a single unit in a multi-unit apartment rental is vacated, the partnership’s cash flow, including yours, will not be as affected since the other units are still generating income.
Economies of scale are something that we hear often when it comes to production. You exploit the inverse relation of increasing output versus the cost to produce said goods. But what does this mean in the real estate context?
Expenses and maintenance costs in apartment syndications are typically far less, compared to managing a portfolio of separate, single-family homes because in syndications all units are, quite literally, under one roof. As the number of rental units increases, net income is also increased as you reduce your cost, making it more cost-effective than managing a portfolio of single-family rentals.
Is Rental Still in Demand?
Now that we’ve discussed a few key points regarding real estate investing—rentals, in particular, let’s take a look at the demand for rentals. While some events or instances might influence families to move outside of the city and to the suburbs, potentially choosing to buy a property instead of renting, the demand for units located in key metropolitan areas will still be there.
Each city, district, and state have factors affecting the rental market, such as median household income, that may or may not hurt rental demand. A higher per capita household income may mean that more people in a certain area are able to buy homes instead of renting. However, it’s still more probable that a larger percentage may not be able to afford one and will continue to rent.
There are also commercial establishments that, due to the nature of their businesses, cannot afford to have their employees work from home. This is one thing that can contribute to steady demand in rental properties, especially in apartment complexes in key locations.
We’ve also seen instances where baby boomers who are approaching retirement, opt to let go of their large family home, and just choose to rent. Young families on the other hand, continue to rent as they save up enough cash to buy their first homes in the future. In both instances, the logical choice would be to choose a place that’s either near where they work or is in the vicinity of establishments they frequent.
Investing in apartment syndications certainly has its merits. People who have opted to invest in multifamily will tell you that it’s a worthwhile and relatively safe investment. We are(insert company name here), and we have been successfully providing our clients with professional guidance in the world of apartment syndications. If you would like to know more, schedule a call with us. We’d be more than happy to discuss details with you. We have a team of experts who can walk you through each step of the process in order to make this investment opportunity as easy as possible.
There’s a lot to learn when you first start thinking about investing in real estate and a lot of decisions to make. One of the very first decisions is whether you want to be an active or passive investor. To decide, you should know what each involves, as well as the pros and cons. Read on to discover which is right for you.
What is an active investor?
An active investor is in control of the property or properties and spends a lot of time ensuring everything is running smoothly. They are responsible for:
Finding the property
Securing financing for the investment
Making a business plan
Executing the plan
Finding and managing the right team members
Talking to property managers
Managing the risks associated
Putting things right when they go wrong
If you have the required time, the idea of starting a new business excites you, and you want to be involved in every aspect of the day-to-day management of your investments, then being an active investor may suit you. Let’s take a look at the pros and cons of being an active investor:
Pros of Active Investing
You are in full control
You know every detail of what’s going wrong or right
If you have sufficient resources, you can be the sole investor and receive all income or profit
Cons of Active Investing
You are responsible for everything
You need to invest the time to learn what you need to know to make the right decisions
You could make costly poor decisions if you don’t have someone experienced to guide you
If you’re not available full-time, it can eat up all your spare time
You are responsible for building the right team and replacing anyone as necessary
If you’re seeking a significant amount of financing from others or institutions, you need to be able to prove why you are a good investment
More of the risk typically rests with you
Renovation budgets can get out of hand quickly, especially if you don’t have a lot of experience evaluating properties or if you get carried away with the finish of the property
If you fail to correctly project your costs, you could end up with a much less healthy profit margin (or even none at all)
What is a passive investor?
A passive investor (also known as a limited partner) is someone who is happy to invest the money and let someone more experienced take on the day-to-day operations. Limited partners invest their money with someone knowledgeable, such as a multifamily syndicator (often referred to as a sponsor).
You will see a return on your investment with little-to-no effort from you. You might compare it to investing in the stock market, where you invest your money in a certain company, but don’t have to deal with the day-to-day operations of that company. However, the difference with multifamily investing is your investment is backed by a solid asset, and often the returns can be better.
Let’s take a look at the pros and cons:
Pros of Passive Investing
You’re essentially hands-free
Your money works for you while you live your life
You can diversify through multiple syndications with the same sponsor or multiple
Your sponsor is incentivized to make a return
Typically less personal risk
Developing a good relationship with a talented sponsor or syndication can result in many profitable investments for you
In many cases, you will receive a “preferred return,” which means you’ll receive your return before the syndicator receives their money
You’re trusting someone with more expertise rather than depending on your own research
Cons of Passive Investing
You have limited control over the business plan (instead, you choose to invest in one that appeals to you with someone you trust)
A high level of trust in your sponsor is required
You need to be someone who knows how to delegate and let people do their work (ideal for busy business owners, doctors, those who have created and sold companies, CEOs, etc.) because you can’t micromanage your sponsor
How Much Money Do I Need to Invest?
If you’re going to actively invest, then that depends entirely on what model you choose. What class property are you looking at? Are you looking at single-family or multifamily properties? In some areas, you can get started for little (a down payment of around $10,000 for a single-family residence) if you are happy to have a large mortgage, though you do need to be aware that you should keep some money aside for emergencies and any periods without a tenant. Do your math meticulously to ensure you have a sound ROI.
If you’re looking to invest passively, you should look to have $50,000 or more, again, depending on the specific properties, areas, and opportunities you’re considering. You won’t need to worry about additional costs, and most syndications aim to offer you a very healthy ROI. Why? Because they want you to invest with them again so they can make you – and them – more money in the future.
So Which is Right for Me?
You’re going to need to do your research, regardless of which style of investing appeals to you most. Obviously, if you plan to actively invest, you’re going to have to do even more because you’ll be making every decision. When you’re investing a lot of money, you need to ensure you’re getting it right.
If you’ve always imagined being an active investor but are worried about the time commitment and making a mistake, starting with passive investing can be a good way to dip your toe and start learning what to look for in the future.
If active investing doesn’t really interest you, but you’ve been interested in property investing due to the security a physical asset brings, then passive is the perfect choice for you. It can offer you all the benefits of investing in real estate, without the steep learning curve or headaches of managing your own properties.
The good news is that just about anyone can invest in real estate, but you need to choose the right investment strategy. If you choose to invest actively but realize it’s not for you, changing your mind can be costly, not to mention stressful. Unless you have prior experience working in real estate, passive investing may be the safer bet. Just ensure you work with a syndicator you believe in that is happy to answer all your questions.
If you’re interested in learning more about investing passively or about our upcoming syndications, please don’t hesitate to contact us.
Maybe you’ve heard of a 1031 Exchange or simply a 1031. A term that got its name from the IRS Code section 1031, it is an exchange or a swap of one property for another that is a powerful tax strategy allowing for the deferral of capital gains taxes.
Anyone who owns real estate can harness the power of the 1031 exchange. Just by following this process, you can replace your property and buy a replacement investment, while deferring tax payment on what you gain from the sale.
Want to know how you can have more cash flow through this investment? Or want to earn passive income without being pummeled by taxes?
In this article, you will find key points regarding the 1031 Exchange – rules and concepts you should know if you are thinking about any kind of real estate investment, and when using the 1031 Exchange to invest in a real estate syndication.
A Better Return on Investment
This exchange into syndication helps you by offering a better return on investment while giving you an increase in cash flow. Therefore, when you exchange it with a larger and more valuable property via syndication, the benefits increase twofold.
Deferring Taxes
With this exchange, you get the ability to buy like-kind property while deferring capital gains taxes. If you continue re-investing into other properties, doing this exchange until your death, the investment will be handed down to the heirs, and the cost of the property will reset to the current investment value allowing you and your heirs to avoid the capital gains tax.
However, if you sell the property and take the proceeds (without reinvesting), you will have to pay the capital gains.
Timeline to Execute the 1031 Exchange
The IRS has a specific time frame in which the 1031 exchange needs to be executed, and it needs to be followed for the exchange to run smoothly.
You have 45 days to identify the asset that you will be acquiring, starting from the day of the sale of your existing asset. The IRS does not allow you to access the funds or to touch the property once you sell it. It is also a requirement that you engage a qualified accommodator to facilitate the transaction.
Once you have identified your next asset, the IRS gives you a further window of time so that you can close on the asset. This means that you have a total of 180 days from the day you complete the sale of the original asset to the closing of your next asset. The IRS has strict rules and a timeline to follow and if you are unable to follow those rules you will have to pay the capital gains.
The Role of Accommodator
The role of the accommodator (a qualified intermediary) is to facilitate the process of the transaction from the sale of your asset to the closing of your next asset.
The intermediary helps you walk through the entire process and steps required for the syndication and makes sure that you never miss the timeline, which is outlined by the IRS. In doing so they will help you avoid a taxable event.
The accommodator you hire must be an independent entity and should not be related to you.
Once you hire the accommodator, you will have to enter agreements, including an Escrow Account Agreement, Like-Kind Exchange Agreement, and others that will allow the intermediary to act on your behalf through the transaction process.
Identification Rules for Next Property
There are some rules set by the IRS that you can use to identify the replacement properties. You must choose to follow at least one of these options.
These rules are:
The 3-property rule
Investors, most of the time, use the 3-property rule to identify up to three properties that might generate more cash flow. This means you can exchange into one or all the replacement properties.
If you want to identify more than three replacement properties, you will have to use the 200% fair market value rule.
200% fair market value rule
What is that? How does it work?
Let us give you an example.
Suppose you sell your property for $2,000,000, and identify up to 3 replacement properties for exchange.
You can identify a fourth or fifth replacement property as long as the sum total value of all the properties combined does not exceed $4,000,000 or twice your property’s selling price.
95% Exception Rule
The 95% Rule allows for you to identify any number of replacement property options, regardless of valuation, provided that you follow through and actually acquire a property or properties that equate to at least 95% of the identified value within the exchange period.
For example if you sell your property for $2,000,000 and then identify more than three properties worth $10,000,000 to exchange into, that is allowed if you actually end up spending at least $9,500,000 or 95% of the identified value within the exchange period.
Can I 1031 Exchange my Residential or Vacation Home?
Your primary residence or vacation home is not qualified for this type of exchange. However, there is an exemption, which is known as Section 121. This is a complicated structure, and you will need to take qualified advice to make sure that the exchange is properly executed.
1031 Exchange is a technique for investors who want to earn passive income from real estate. You need a clear understanding of the process so as to leverage it correctly. The procedure can be complicated and that’s why most investors prefer to work with experienced partners.
Our aim is to help you grow your wealth. We are here to help you with the 1031 exchange so that you can enjoy the benefits that apartment syndication provides.
Apartment syndication has been a strong buzzword in society, especially since the JOBS Act passed back in 2012 that boosted real estate crowdfunding. All in all, apartment syndication is an inked transaction between a general partner/sponsor and a group of passive partner investors to adequately fund a property that holds high credibility to drive optimal financial gains. Now, as clear-cut as this process may seem on the surface for all parties involved, there is one leading and fully justified question that arises amongst potential passive investors – how do general partners make money from this deal?
In summary, the answer to this question is quite dynamic, as there are several ways general partners can (and do) make money from apartment syndication. To offer more insight and clarity within this area, below is a comprehensive overview of the diverse streams a general partner has that allows them to get compensated for their role.
1. Distributions
First are distributions, which is an umbrella term that consists of operations, refinancing, and the sale of the property. Depending on the written contract and how much everyone invested will determine what the split and payout will be. For instance, the profit split could be a clean 50/50 between a passive partner and the general partner, or it could be as tilted as 90/10. As long as everyone agrees, the profits can be split equally, or each person could obtain a different return based on the X/X ratio listed.
Example: If a passive partner with an 8% preferred return invested $2,000,000 into a property that earned an annual cash flow of $200,000, they would receive $160,000 along with an additional $20,000 if the contract was a 50/50 split. That scenario would leave the general partner with $20,000 to take.
2. Percentage Ownership
Another primary way, which is also linked to the distribution point above, is making money through percentage ownership. Again, depending on how much personal investment the general partner chose to invest and how much the property refinanced or sold for will determine the outcome of this profit. An example for this one is the general partner owning 30% of the property and the passive partners owning 70% of it. The only underlying issue with this one is that it does not usually offer steady cash flow over time, but it could deliver large lump sums in the end if the value of the property rose significantly.
3. Fees
Next involves general partner fees. In short, there are typically a few different fees involved in an apartment syndication agreement, one of which is an acquisition fee. Almost all general partners will charge this one-time upfront fee, usually around 1-5% of the total purchase price. This profit will again be strongly determined on the potential of the property, the qualifications of the team, and the scope of the project as a whole. Why do you, as a passive partner, need to pay this? Because it covers the time and money spent by the general partner on their efforts involving deal development, team building, marketing analysis work, finance securing, and other aspects involved to make the project a successful and seamless one. Other fees that a passive partner can expect to pay and how general partners get paid for their time include:
Asset Management Fee: An annual per unit fee ranging from about 2-3% and is used to cover aspects within the business plan such as interior/exterior renovations. An important thing to note here is that this percentage is based on what the collected income is, meaning the lower the income, the lower the percentage will be.
Organization Fee: The majority of the time, most apartment syndication contracts do not list an organization fee as it is built into the acquisition fee. However, if it is separate, then a general partner will likely ask for a 3-10% upfront fee based on the total money that has been raised to organize and orchestrate the project team fundamentals.
Refinance Fee: A refinance fee goes to a general partner for their time involved in refinancing a property. Perhaps the value increases as time goes on, and they are able to refinance with a better interest rate and terms. Refinancing is not always applicable, but if it is, there may be a 1-3% fee collected based on the total loan amount.
Loan Guarantor Fee: This is another one-time closing fee (that a general partner may or may not ask for) which is collected to guarantee the loan. This one had a larger percentage range falling anywhere from .5% to 5%, depending on the risk involved and if it is a recourse loan or not. Diving deeper into the risks, a recourse loan is red on the risk chart because it allows the lender to collect the general partner’s assets (home, car, credit cards, etc.) even after the collateral has been taken to collect the debt owed. On the other hand, a nonrecourse does not allow the lender to collect assets other than the collateral. In those circumstances, the loan guarantor fee will be lower since there is less risk on the general partner.
Loan Interest Fees: Regardless of the size of the loan being taken on to carry out the property renovating objectives, there is going to be interest involved. Because of this, there might be an 8-12% loan interest fee as part of the apartment syndication deal. This fee is to help cover that said interest incurred from the loans made to the company.
Construction Management Fee: Lastly, a construction management fee is typically an on-going 5-10% fee to support the general partner in optimizing the project pipeline efforts. This percentage is calculated on the total renovation budget, but keep in mind that it is often intertwined with the asset management fee to maximize passive partner returns.
4. Brokerage Commissions (If Licensed A Broker in The Same State as The Property)
If a general partner happens to be a licensed real estate broker in the same state as the property they are investing in, then they could earn compensation for that area of business as well for performing brokerage activities to the syndication. For instance, they may earn a commission for purchasing the property initially and potentially a resale commission if selling the flipped property is part of the big picture agenda. As a final comment here, if a general partner is not a licensed broker, then onboarding one will be part of their team building process, as they are the main link between the buyer and seller and helps ensure that the entire acquisition process will go smoothly.
Conclusion – Ready to Invest Passively?
From finding and underwriting deals, securing finances, negotiating, executing business plans to investor communications, general partners are essentially the drivers when it comes to apartment syndication. Because of that, it stands to reason why many people looking to invest passively stop and ask how do general partners make money as their role significantly differs from theirs. After reviewing the list of streams above, hopefully you now have a better understanding of how the process works on that side of the spectrum and have a concrete idea of what to expect if you choose to opt for this investing avenue yourself.
With that being said, passive investing is one of the leading ways to obtain the advantages of owning an apartment property without having to put in the full time, commitment, and funding needed to execute the project. Now, this is certainly not a get rich quick scheme, but it is one that can hold monumental value that builds over time. Remember, when a multifamily property you invested in earns a profit, so do you! Overall, if you are ready to have your money work for you and invest passively in multifamily real estate, then contact us today, and we will be happy to help you get the process started.
As an investor, there are various ways you could put your money to work. When you’re in the world of private placements, you may have heard of preferred returns. These refer to the order in which profits from a project are distributed to investors. Preferred return indicates a contractual entitlement to distributions of profit. Those who were promised preferred returns are given priority when the distribution of profits happens. This is maintained until a predetermined threshold rate of return has been met.
Preferred returns are usually expressed as a percentage of return on an annual basis. For example, if in an agreement you were promised a preferred return of 8% for a $100,000 investment, then you would receive $8,000 ($100,000 x 0.08) in annual return if available from the net revenue.
As an investor, the rate of preferred return is a vital component in checking the health of a particular investment, as it reveals the intent of your partners in returning your money. When you have preferred returns, you’re given priority over the company’s income before the general shareholders. That means the people running the company should work hard enough to not only meet the promised preferred returns but also generate enough excess income to be profitable.
In short, the operators will be focused on reducing the time spent before you get your return on investment, to increase your overall return. This will ensure that your goals as an investor and the goals of those running the company are in sync, and no one is out to cut the other short.
By the nature of preferred returns, it is indeed more advantageous to the one with the capital. Thus, when you’re offered an investment, it pays to look for this clause. An operator may choose not to offer preferred returns because doing so will delay their split of the profits. While this is acceptable, as an investor, you may see this as a misalignment of interest. Another reason why operators may not offer preferred returns is if they are not as well-capitalized and need the proceeds from the cash flow to fund their syndication operations.
Types of Preferred Returns
Now that we’ve talked about preferred returns, let’s discuss their types.
The first is cumulative versus non-cumulative. When you’re tasked to review a private placement memorandum (PPM), you will want to make sure that you take note of whether it’s a cumulative preferred return. Cumulative preferred return is ideal because it will help protect your overall return and here’s why.
Remember our example earlier? Let’s say you’re given a preferred return of 8% per annum. In a non-cumulative preferred return, if you do not receive your total preferred return for one year, then you lose the difference. Say, in year 1 you receive back 6% (rather than the 8% that was anticipated). With a non-cumulative return, youforfeit the right of getting the difference after that year has elapsed. Every year the preferred return resets and does not carry forward.
A cumulative preferred return gives you the right to add the difference and roll it over to the next year. For example, if your preferred return was 8% and you only received 6% one year, then your preferred return the following year would increase to 10% (8% + 2%).
In the normal business cycle, cash flows are expected to increase year to year as operations begin to stabilize and become more profitable. Thus, while the promised return in percentage is fixed, the actual value of such will be bigger since the number where it’s computed from also gets bigger as the years pass. This can lead you to get a return on investment sooner.
As a reminder, always read your documents carefully to be aware of whether you are investing in projects with a cumulative preferred return.
Another type of preferred return is the preferred return with catch-up. This setup is considered the second position in the waterfall distribution schedule. Here, once your share of the profit is achieved and is set aside, the operator receives all or most of the profits until the operator “catches up” and reaches the same portion of equity you received. This type of catchup provision allows the operator to receive its entire equity split as originally agreed by both parties.
What Else To Know
Another aspect that you should know about concerning PPMs is the difference between Preferred Returns and Preferred Equity. To differentiate both, let’s go back to the life cycle of the investment. Assuming that funding is already secured, your investment can either be with a preferred return, preferred equity, or both. We discussed how preferred returns work. When it comes to preferred returns, the actual return of your overall capital is not in the picture.
When you have preferred equity, you’re prioritized to get your returns during the hold period and also have a priority treatment to get back your initial capital when the asset is sold.
So it is a good business practice to consider adding an equal amount of preferred equity and preferred returns in your portfolio for risk management purposes. Preferred returns help you with a steadier, consistent cash flow; while as a preferred equity investor, you would receive your specified return and your initial capital back before any of the other investors.
When Do Preferred Returns Go Away?
Preferred returns are often calculated based on how much capital you contributed times the interest promised. However, there are distribution structures where your payouts are deducted from your capital. Thus, every payment you receive means a return from the capital you invested. This will also mean that since your returns are based on your unpaid capital, then it’s safe to assume that you will get smaller payments over time.
Some operators will say that this is a good idea because you are not paying taxes on the cash flow. However, since your preferred returns are based on unreturned capital contributions, your preferred returns will gradually diminish. Some operators prefer this structure because it allows them to achieve profitability quicker.
As an investor, It’s generally better to choose preferred returns that are distributed from profits alone and not deducted from your initial capital so that your payouts will not be diminished. Typically you do not have to worry about the taxes right now anyway, since the depreciation each year should offset all the distributions you receive.
You also do not have to worry about the return in the capital, as preferred returns are not the most efficient way to get it back. Usually, to reduce your unreturned capital contributions or get it back completely, you need to go through a capital event such as a refinance or supplemental loan. Through these events, you would receive a portion of your initial capital back and this amount would reduce your unreturned capital contributions.
To make the above example less confusing, let’s pick up from our last scenario. You invested $100,000 and because of this, you will be getting an 8% preferred return rate (or $8,000 a year). Instead of deducting this amount from the initial capital, treat it as a dividend gain. In year three, when the operations have stabilized and the company is ripe and due for refinancing, that’s the time you can lobby to get a portion of your capital back. Your preferred return would then be based on the remaining unpaid capital. Thus, if during the said refinancing you were able to get around $40,000 back, then you will still be able to enjoy the fruits of the 8% preferred return rate on the $60,000.
With this example, it is important to note that even though your unreturned capital was reduced, this does not reduce your equity position in the overall deal. This amount is only used to calculate your preferred returns. However, some operators will reduce your equity position during a refinance or supplement loan, so be very diligent in reading the PPMs to make sure you know exactly what you are getting yourself into from the start.
Conclusion
Remember that just as with any venture you may get into, always protect your capital first. That’s the basic rule of risk management. Do not look so far ahead, especially to the potential gains, and overlook the red flags and risks that might be lurking in the PPM. Look at preferred returns as a powerful tool for you to protect your capital. It allows you to have preferential treatment in getting back your capital (and more) and eventually helps you grow your portfolio as a passive investor. By carefully choosing preferred returns, you reduce your risk when putting your money in private placements, since you are prioritized to receive the proceeds of all cash flows first.
